Economic Policy

Monetary Policy

Monetary policy is the process by which the monetary authority of a country controls the supply of money.

Learning Objectives

Describe how central banking authorities use monetary policy to achieve the twin economic goals of relatively stable prices and low unemployment

Key Takeaways

Key Points

  • Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding.
  • Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.
  • Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.
  • The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies.

Key Terms

  • Expansionary policy: Expansionary policy increases the total supply of money in the economy more rapidly than usual.
  • monetary policy: Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.
  • Contractionary policy: Contractionary policy expands the money supply more slowly than usual or even shrinks it.

Monetary Policy

Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values.

Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.

Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate to achieve policy goals. The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard.

Monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.

There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements with the effect of contracting the money supply; and, if reversed, expand the money supply.

Within almost all modern nations, special institutions, central banks, (the Federal Reserve System in the United States) have the task of executing the monetary policy and often independently of the executive.

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The Federal Reserve Board Building: The Federal Reserve Board Building in Washington D. C.

The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation.

Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.

The other primary means of conducting monetary policy include:

  1. Discount window lending (lender of last resort)
  2. Fractional deposit lending (changes in the reserve requirement)
  3. Moral suasion (cajoling certain market players to achieve specified outcomes)
  4. “Open mouth operations” (talking monetary policy with the market).

Fiscal Policy

Fiscal policy is the use of government revenue collection or taxation, and expenditure (spending) to influence the economy.

Learning Objectives

Review the United States’ stances of fiscal policy, methods of funding, and policies regarding borrowing

Key Takeaways

Key Points

  • There are three main stances of fiscal policy: neutral fiscal policy, expansionary fiscal policy, and contractionary fiscal policy.
  • Governments can use a budget surplus to do two things: to slow the pace of strong economic growth and to stabilize prices when inflation is too high.
  • However, economists debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out.
  • In the classical view, the expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income.

Key Terms

  • Keynesian Economics: Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand, and only to decrease spending & increase taxes after the economic boom begins.
  • fiscal policy: In economics and political science, fiscal policy is the use of government revenue collection or taxation, and expenditure (spending) to influence the economy.
  • Neoclassical Economists: Neoclassical economists generally emphasize crowding out; when government borrowing leads to higher interest rates that may offset the stimulative impact of spending.

Fiscal Policy

In economics and political science, fiscal policy is the use of government revenue collection or taxation, and expenditure (spending) to influence the economy. Changes in the level and composition of taxation and government spending can impact the following variables in the economy: aggregate demand and the level of economic activity; the pattern of resource allocation; and the distribution of income.

Stances of Fiscal Policy

There are three main stances of fiscal policy:

  • Neutral fiscal policy is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
  • Expansionary fiscal policy involves government spending exceeding tax revenue, and is usually undertaken during recessions.
  • Contractionary fiscal policy occurs when government spending is lower than tax revenue, and is usually undertaken to pay down government debt.

However, these definitions can be misleading as, even with no changes in spending or tax laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues and of some types of government spending, altering the deficit situation; these are not considered to be policy changes. Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral fiscal policy stance.

Methods of Funding

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways: taxation, printing money, borrowing money from the population or from abroad, consumption of fiscal reserves, or sale of fixed assets (land).

Borrowing

A fiscal deficit is often funded by issuing bonds. These pay interest, either for a fixed period or indefinitely. If the interest and capital requirements are too large, a nation may default on its debts, usually to foreign creditors, while public debt or borrowing refers to the government borrowing from the public.

Economic Effects of Fiscal Policy

Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. One school of fiscal policy developed by John Maynard Keynes suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand, and only to decrease spending & increase taxes after the economic boom begins. Keynesian Economics argues this method be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment. In theory, the resulting deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.

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John Maynard Keynes and Harry Dexter White: Keynes (right) was the father and founder of Keynesian economics.

Governments can use a budget surplus to do two things: to slow the pace of strong economic growth and to stabilize prices when inflation is too high. Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices.

However, economists debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out; whether government borrowing leads to higher interest rates that may offset the stimulative impact of spending. When the government runs a budget deficit, funds will need to come from public borrowing ( government bonds ), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus. Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding out is minimal.

In the classical view, the expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. To purchase bonds originating from a certain country, foreign investors must obtain that country’s currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country’s currency increases. The increased demand causes that country’s currency to appreciate. Once the currency appreciates, goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase.

Income Security Policy

Fiscal policy is considered to be any change the government makes to the national budget in order to influence a nation’s economy.

Learning Objectives

Analyze the transformation of American fiscal policy in the years of the Great Depression and World War II

Key Takeaways

Key Points

  • The Great Depression showed the American population that there was a growing need for the government to manage economic affairs. The size of the federal government began rapidly expanding in the 1930s, growing from 553,000 paid civilian employees in the late 1920s to 953,891 employees in 1939.
  • FDR was important because he implicated the New Deal, a program that would offer relief, recovery, and reform to the American nation. In terms of relief, new organizations (such as the Works Progress Administration) saved many U.S. lives.
  • In 1971, at Bretton Woods, the U.S. went off the gold standard, allowing the dollar to float. Shortly after that, OPEC pegged the price of oil to gold rather than the dollar. The 70s were marked by oil shocks, recessions, and inflation in the U.S.
  • Fixed income refers to any type of investment under which the borrower/issuer is obliged to make payments of a fixed amount on a fixed schedule: for example, if the borrower has to pay interest at a fixed rate once a year, and to repay the principal amount on maturity.
  • Fixed-income securities can be contrasted with equity securities, often referred to as stocks and shares, that create no obligation to pay dividends or any other form of income.
  • Governments issue government bonds in their own currency and sovereign bonds in foreign currencies. Local governments issue municipal bonds to finance themselves. Debt issued by government-backed agencies is called an agency bond.

Key Terms

  • fiscal: Related to the treasury of a country, company, region, or city, particularly to government spending and revenue.
  • fixed income: Fixed income refers to any type of investment under which the borrower/issuer is obliged to make payments of a fixed amount on a fixed schedule: for example, if the borrower has to pay interest at a fixed rate once a year, and to repay the principal amount on maturity.

Background

Any changes the government makes to the national budget in order to influence a nation’s economy is considered fiscal policy. The approach to economic policy in the United States was rather laissez-faire until the Great Depression. The government tried to stay away from economic matters as much as possible and hoped that a balanced budget would be maintained.

Fixed income refers to any type of investment under which the borrower/issuer is obliged to make payments of a fixed amount on a fixed schedule: for example, if the borrower has to pay interest at a fixed rate once a year, and to repay the principal amount on maturity. Fixed-income securities can be contrasted with equity securities, often referred to as stocks and shares, that create no obligation to pay dividends or any other form of income. In order for a company to grow its business, it often must raise money: to finance an acquisition, buy equipment or land or invest in new product development. Governments issue government bonds in their own currency and sovereign bonds in foreign currencies. Local governments issue municipal bonds to finance themselves. Debt issued by government-backed agencies is called an agency bond.

The Great Depression

The Great Depression struck countries in the late 1920s and continued throughout the entire 1930s. It affected some countries more than others, and the effects in the U.S. were detrimental. In 1933, around 25% of all workers were unemployed in America. Many families starved or lost their homes. Some tried traveling to the West to find work, also to no avail. Because of the prolonged recovery of the United States economy and the major changes that the Great Depression forced the government to make, the creation of fiscal policy is often referred to as one of the defining moments in the history of the United States.

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Crowds outside the New York Stock Exchange in 1929.: A solemn crowd gathers outside the Stock Exchange after the crash.

Another contributor to changing the role of government in the 1930s was President Franklin Delano Roosevelt. FDR was important because he implicated the New Deal, a program that would offer relief, recovery, and reform to the American nation. In terms of relief, new organizations (such as the Works Progress Administration) saved the lives of many U.S. citizens. The reform aspect was indeed the most influential in the New Deal, as it forever changed the role of government in the U.S. economy.

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FDR: FDR’s “New Deal” policies were based on the principle of government intervention and regulation of the economy.

World War II and Effects

World War II forced the government to run huge deficits, or spend more than they were generating economically, in order to keep up with all of the production the U.S. military needed. By running deficits, the economy recovered, and America rebounded from its drought of unemployment. The military strategy of full employment had a huge benefit: the government’s massive deficits were used to pay for the war, and ended the Great Depression. This phenomenon set the standard and showed just how necessary it was for the government to play an active role in fiscal policy.

Modern Fiscal Policy

In 1971, at Bretton Woods, the U.S. went off the gold standard, allowing the dollar to float. Shortly after that, OPEC pegged the price of oil to gold rather than the dollar. The 70s were marked by oil shocks, recessions, and inflation in the U.S.

In late 2007 to early 2008, the economy would enter a particularly bad recession as a result of high oil and food prices, and a substantial credit crisis leading to the bankruptcy and eventual federal takeover of certain large and well-established mortgage providers. In an attempt to fix these economic problems, the United States federal government passed a series of costly economic stimulus and bailout packages. As a result of this, the deficit would increase to $455 billion and is projected to continue to increase dramatically for years to come, due in part to both the severity of the current recession and the high spending fiscal policy the federal government has adopted to help combat the nation’s economic woes.

Regulation and Antitrust Policy

Antitrust laws are a form of marketplace regulation intended to prohibit monopolization and unfair business practices.

Learning Objectives

Assess the balance the federal government attempts to strike between regulation and deregulation

Key Takeaways

Key Points

  • A number of governmental programs review regulatory innovations in order to minimize and simplify those regulations, and to make regulations more cost-effective.
  • Government agencies known as competition regulators, as well as private litigants, apply antitrust and consumer protection laws in the hopes of preventing market failure.
  • Large companies with huge cash reserves and large lines of credit can stifle competition by engaging in predatory pricing, in which they intentionally sell their products and services at a loss for a time, in order to force smaller competitors out of business.

Key Terms

  • Antitrust Law: The United States antitrust law is a body of law that prohibits anti-competitive behavior (monopolization) and unfair business practices. Antitrust laws are intended to encourage competition in the marketplace.
  • regulation: A regulation is a legal provision that creates, limits, or constrains a right; creates or limits a duty; or allocates a responsibility.

A regulation is a legal provision with many possible functions. It can create or limit a right; it can create or limit a duty; or it can allocate a responsibility. Regulations take many forms, including legal restrictions from a government authority, contractual obligations, industry self-regulations, social regulations, co-regulations, and market regulations.

State, or governmental, regulation attempts to produce outcomes which might not otherwise occur. Common examples of this type of regulation include laws that control prices, wages, market entries, development approvals, pollution effects, employment for certain people in certain industries, standards of production for certain goods, the military forces, and services.

The study of formal (legal and/or official) and informal (extra-legal and/or unofficial) regulation is one of the central concerns of the sociology of law. Scholars in this field are particularly interested in exploring the degree to which formal and legal regulation actually changes social behavior.

Deregulation, Regulatory Reform, and Liberalization

According to the Competitive Enterprise Institute, government regulation in the United States costs the economy approximately $1.75 trillion per year, a number that exceeds the combined total of all corporate pretax profits. Because of this, programs exist that review regulatory initiatives in order to minimize and simplify regulations, and to make them more cost-effective. Such efforts, given impetus by the Regulatory Flexibility Act of 1980 in the United States, are embodied in the United States Office of Management and Budget ‘s Office of Information and Regulatory Affairs. Economists also occasionally develop regulation innovations, such as emissions trading.

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U.S. Department of Justice: The Department of Justice is home to the U.S. anti-trust enforcers.

U.S. Antitrust Law

U.S. antitrust law is a body of law that prohibits anti-competitive behavior (monopolization) and unfair business practices. Intended to encourage competition in the marketplace, these laws make it illegal for businesses to employ practices that hurt other businesses or consumers, or that generally violate standards of ethical behavior. Government agencies known as competition regulators, along with private litigants, apply the antitrust and consumer protection laws in hopes of preventing market failure. Originally, these types of laws emerged in the U.S. to combat “corporate trusts,” which were big businesses. Other countries use the term “competition law” for this action. Many countries, including most of the Western world, have antitrust laws of some form. For example, the European Union has provisions under the Treaty of Rome to maintain fair competition, as does Australia under its Trade Practices Act of 1974.

Antitrust Rationale

Antitrust laws prohibit monopolization, attempted monopolization, agreements that restrain trade, anticompetitive mergers, and, in some circumstances, price discrimination in the sale of commodities.

Monopolization, or attempts to monopolize, are offenses that an individual firm may commit. Typically, this behavior involves a firm using unreasonable, unlawful, and exclusionary practices that are intended to secure, for that firm, control of a market. Large companies with huge cash reserves and large lines of credit can stifle competition by engaging in predatory pricing, in which they intentionally sell their products and services at a loss for a time, in order to force smaller competitors out of business. Afterwards, with no competition, these companies are free to consolidate control of an industry and charge whatever prices they desire.

A number of barriers make it difficult for new competitors to enter a market, including the fact that entry requires a large upfront investment, specific investments in infrastructure, and exclusive arrangements with distributors, customers and wholesalers. Even if competitors do shoulder these costs, monopolies will have ample warning and time in which to either buy out the competitor, engage in its own research, or return to predatory pricing long enough to eliminate the upstart business.

Federal Antitrust Actions

The federal government, via the Antitrust Division of the United States Department of Justice, and the Federal Trade Commission, can bring civil lawsuits enforcing the laws. Famous examples of these lawsuits include the government’s break-up of AT&T’s local telephone service monopoly in the early 1980s, and governmental actions against Microsoft in the late 1990s.

The federal government also reviews potential mergers to prevent market concentration. As a result of the Hart-Scott-Rodino Antitrust Improvements Act, larger companies attempting to merge must first notify the Federal Trade Commission and the Department of Justice’s Antitrust Division prior to consummating a merger. These agencies then review the proposed merger by defining what the market is, and then determining the market concentration using the Herfindahl-Hirschman Index and each company’s market share. The government is hesitant to allow a company to develop market power, because if unchecked, such power can lead to monopoly behavior.

Exemptions to Antitrust Laws

Several types of organizations are exempt from federal antitrust laws, including labor unions, agricultural cooperatives, and banks. Mergers and joint agreements of professional football, hockey, baseball, and basketball leagues are exempt. Newspapers run by joint operating agreements are also allowed limited antitrust immunity under the Newspaper Preservation Act of 1970.

Subsidies and Contracting

A subsidy is assistance paid to business, economic sectors, or producers; a contract is an agreement between two or more parties.

Learning Objectives

Discuss the aims of subsidies and their effects on supply and demand

Key Takeaways

Key Points

  • Subsidies are often regarded as a form of protectionism or trade barrier by making domestic goods and services artificially competitive against imports. Subsidies may distort markets and can impose large economic costs.
  • A subsidy may be an efficient means of correcting a market failure. For example, economic analysis may suggest that direct subsidies (cash benefits) would be more efficient than indirect subsidies (such as trade barriers).
  • Government procurement in the United States addresses the federal government’s need to acquire goods, services (including construction), and interests in real property.
  • The authority of a contracting officer (the Government’s agent) to contract on behalf of the Government is set forth in public documents (a warrant ) that a person dealing with the contracting officer can review.

Key Terms

  • subsidy: Assistance paid to a business, economic sector, or producers.
  • Contract: An agreement entered into voluntarily by two or more parties with the intention of creating a legal obligation, which may have elements in writing, though contracts can be made orally.

Subsidy

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Subsidies: This graph depicts U.S. farm subsidies in 2005.

A subsidy is assistance paid to a business, economic sector or producers. Most subsidies are paid by the government to producers or distributed as subventions in an industry to prevent the decline of that industry, to increase the prices of its products, or simply to encourage the hiring of more labor. Some subsidies are to encourage the sale of exports; some are for food to keep down the cost of living; and other subsidies encourage the expansion of farm production.

Examples of industries or sectors where subsidies are often found include utilities, gasoline in the United States, welfare, farm subsidies, and (in some countries) certain aspects of student loans.Subsidies are often regarded as a form of protectionism or trade barrier by making domestic goods and services artificially competitive against imports. Subsidies may distort markets and can impose large economic costs. Financial assistance in the form of subsidies may come from a government, but the term subsidy may also refer to assistance granted by others, such as individuals or non-governmental institutions.

Types of Subsidies

Ways to classify subsidies include the reason behind them, the recipients of the subsidy, and the source of the funds. One of the primary ways to classify subsidies is the means of distributing the subsidy. The term subsidy may or may not have a negative connotation. A subsidy may be characterized as inefficient relative to no subsidies; inefficient relative to other means of producing the same results; or “second-best;” implying an inefficient but feasible solution.

In other cases, a subsidy may be an efficient means of correcting a market failure. For example, economic analysis may suggest that direct subsidies (cash benefits) would be more efficient than indirect subsidies (such as trade barriers); this does not necessarily imply that direct subsidies are bad, but they may be more efficient or effective than other mechanisms to achieve the same (or better) results. Insofar as they are inefficient, subsidies would generally be considered bad, as economics is the study of efficient use of limited resources.

Effects

In standard supply and demand curve diagrams, a subsidy shifts either the demand curve up or the supply curve down. Subsidies that increase the production will tend to result in lower prices, while subsidies that increase demand will tend to result in an increase in price. Both cases result in a new economic equilibrium. The recipient of the subsidy may need to be distinguished from the beneficiary of the subsidy, and this analysis will depend on elasticity of supply and demand as well as other factors. The net effect and identification of winners and losers is rarely straightforward, but subsidies generally result in a transfer of wealth from one group to another (or transfer between sub-groups).

Government Procurement

Government procurement in the United States addresses the federal government’s need to acquire goods, services (including construction), and interests in real property. It involves the acquiring by contract, usually with appropriated funds, of supplies, services, and interests in real property by and for the use of the Federal Government. This is done through purchase or lease, whether the supplies, services, or interests are already in existence or must be created, developed, demonstrated, and evaluated.

The authority of a contracting officer (the Government’s agent) to contract on behalf of the Government is set forth in public documents (a warrant) that a person dealing with the contracting officer can review. The contracting officer has no authority to act outside of his or her warrant or to deviate from the laws and regulations controlling Federal Government contracts. The private contracting party is held to know the limitations of the contracting officer’s authority, even if the contracting officer does not. This makes contracting with the United States a very structured and restricted process. As a result, unlike in the commercial arena, where the parties have great freedom, a contract with the U.S. Government must comply with the laws and regulations that permit it, and must be made by a contracting officer with actual authority to execute the contract.

The Public Debt

Government debt, also known as public debt, or national debt, is the debt owed by a central government.

Learning Objectives

Describe how countries finance activities by issuing debt

Key Takeaways

Key Points

  • Government debt is one method of financing government operations but not the only method. Governments can also create money to monetize their debts, thus removing the need to pay interest. However, this practice simply reduces government interest costs rather than truly canceling government debt.
  • As the government draws its income from much of the population, government debt is an indirect debt of the taxpayers.
  • Lending to a national government in the country’s own currency is often considered risk free and is done at a so-called risk-free interest rate. This is because, up to a point, the debt and interest can be repaid by raising tax receipts, a reduction in spending, or by simply printing more money.

Key Terms

  • Public Debt: Government debt, also known as public debt, or national debt, is the debt owed by a central government.
  • Sovereign Debt: Sovereign debt usually refers to government debt that has been issued in a foreign currency.
  • Government Bond: A government bond is a bond issued by a national government. Such bonds are often denominated in the country’s domestic currency.

Government Debt

Government debt, also known as public debt, or national debt, is the debt owed by a central government. In the U.S. and other federal states, “government debt” may also refer to the debt of a state or provincial government, municipal or local government. Government debt is one method of financing government operations, but it is not the only method. Governments can also create money to monetize their debts, thereby removing the need to pay interest. However, this practice simply reduces government interest costs rather than truly canceling government debt. shows each country’s public debt as a percentage of their GDP in 2011.

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Global Public Debt: This map shows each country’s public debt as a percentage of their GDP.

Governments usually borrow by issuing securities, government bonds and bills. Less creditworthy countries sometimes borrow directly from a supranational organization (the World Bank) or international financial institutions. As the government draws its income from much of the population, government debt is an indirect debt of the taxpayers. Government debt can be categorized as internal debt (owed to lenders within the country) and external debt (owed to foreign lenders). Sovereign debt usually refers to government debt that has been issued in a foreign currency. A broader definition of government debt may consider all government liabilities, including future pension payments and payments for goods and services the government has contracted but not yet paid.

Government and Sovereign Bonds

A government bond is a bond issued by a national government. Such bonds are often denominated in the country’s domestic currency. Most developed country governments are prohibited by law from printing money directly, that function having been relegated to their central banks. However, central banks may buy government bonds in order to finance government spending, thereby monetizing the debt.

Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. Investors in sovereign bonds denominated in foreign currency have the additional risk that the issuer may be unable to obtain foreign currency to redeem the bonds.

Denominated in Reserve Currencies

Governments often borrow money in currency in which the demand for debt securities is strong. An advantage of issuing bonds in a currency such as the US dollar, the pound sterling, or the euro is that many investors wish to invest in such bonds.

Risk

Lending to a national government in the country’s own sovereign currency is often considered “risk free” and is done at a so-called “risk-free interest rate. ” This is because, up to a point, the debt and interest can be repaid by raising tax receipts (either by economic growth or raising tax rates), a reduction in spending, or failing that by simply printing more money. It is widely considered that this would increase inflation and reduce the value of the invested capital. A typical example of this is provided by Weimar Germany of the 1920s which suffered from hyperinflation due to its government’s inability to pay the national debt deriving from the costs of World War I.

In practice, the market interest rate tends to be different for debts of different countries. An example is in borrowing by different European Union countries denominated in euros. Even though the currency is the same in each case, the yield required by the market is higher for some countries’ debt than for others. This reflects the views of the market on the relative solvency of the various countries and the likelihood that the debt will be repaid.

A politically unstable state is anything but risk-free as it may cease its payments. Another political risk is caused by external threats. It is mostly uncommon for invaders to accept responsibility for the national debt of the annexed state or that of an organization it considered as rebels. For example, all borrowings by the Confederate States of America were left unpaid after the American Civil War. On the other hand, in the modern era, the transition from dictatorship and illegitimate governments to democracy does not automatically free the country of the debt contracted by the former government. Today’s highly developed global credit markets would be less likely to lend to a country that negated its previous debt, or might require punishing levels of interest rates that would be unacceptable to the borrower.

U.S. Treasury bonds denominated in U.S. dollars are often considered “risk free” in the U.S. This disregards the risk to foreign purchasers of depreciation in the dollar relative to the lender’s currency. In addition, a risk-free status implicitly assumes the stability of the US government and its ability to continue repayments during any financial crisis.

Lending to a national government in a currency other than its own does not give the same confidence in the ability to repay, but this may be offset by reducing the exchange rate risk to foreign lenders. Usually small states with volatile economies have most of their national debt in foreign currency.